Should investors be buying these battered spread betting stocks?

Updated: 
IG Group

Shares in the UK's two leading spread betting firms, IG Group(LSE: IGG) and CMC Markets (LSE: CMCX), have been in the doldrums since the Financial Conduct Authority (FCA) announced proposals to tighten industry regulation back in December. However, following a series of better-than-expected trading updates from the sector in recent months, is it time to pile back in?

Results

IG became the latest spread betting firm to report higher trading revenue today, following Plus500 earlier this month. Net trading revenue rose 7.6% to £491.1m in the year to 31 May, as the group significantly expanded its customer base against the backdrop of unusually low levels of volatility in global financial markets.

The firm attracted 38% more new clients than last year, leading its client base to grow 18% in the year to 185,800. However, as the group's operating expenses increased 14%, following a step-up in advertising and marketing costs, pre-tax profits grew more modestly, by just 2.8% to £213.7m.

As IG continues to expand internationally and into share-dealing, it's not just growing in profitability, but reducing its exposure to regulatory risks in the UK retail leveraged OTC market. The share of the group's revenues coming from UK CFD and spreadbets declined from 52% in 2012, to 45% last year. CMC has an even smaller share, with just 38% of its revenues coming from UK leveraged trades.

Dividends

IG also today said it would pay a final dividend of 22.88p per share, taking its total payout to 32.3p per share. This represents an increase of 2.9% on the previous year, and gives its shares a tempting yield of 5.3%.

CMC has an even higher dividend yield of 6.1%. On the downside though, the company is doing less well in growing its client base and revenue per client has fallen at a much faster rate. In the year to 31 March, its number of active clients rose 5% to 60,082, while revenue per client fell 11% to £2,517. This caused pre-tax profits to fall 9% to £48.5m.

Regulatory risks

It's important to be cautious with these results as the regulatory crackdown on the industry has yet to happen. It's difficult to predict the impact and there's considerable uncertainty over which of the proposed new measures will be adopted and the timing of regulatory decisions.

But don't forget that regulation can bring benefits too, especially for larger firms that target experienced, long-term clients. As the proposed new rules are intended to improve client outcomes, they could help the industry retain customers for longer. Spread betting firms spend tens of millions chasing new customers because so many of their retail clients lose money -- but if fewer clients lose money, then companies may find it easier to keep them.

Stricter regulation also tends to encourage industry consolidation, as the burden of compliance generally hits smaller firms disproportionately. A smaller number of larger firms would likely ease competitive pressures, and potentially boost profits too.

Bottom line

IG and CMC's focus on the higher end of the market means that they are not the intended targets of the FCA's proposed regulatory changes. Although, they will likely suffer some collateral damage from regulatory action in the short term, the longer-term impact is unclear. Personally, I reckon the likelihood that these firms will continue to adapt and thrive is high.

Valuations still look cheap, with shares in both firms trading at less than 13 times forward earnings.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.